Thursday, March 31, 2011

The pension system for California's teachers has $56 billion less than it needs to cover the benefits promised to its 852,000 members and their families, the fund reported Thursday, as big investment losses in 2008 continue to reverberate.

The drop in value was enough to trigger an automatic increase in the amount the state must pay into the California State Teachers' Retirement System, which is the nation's second largest public pension fund. That will boost the payment from California's already strained general fund by 20 percent — from $573 million to $688 million — in the fiscal year starting July 1.

The pension shortfall as of June 30, 2010, was $15.5 billion greater than it had been a year earlier, CalSTRS officials said. The fund had expected the shortfall to be even greater, but educators received smaller raises than projected, reducing the ultimate amount of their retirement benefits, and the fund's investments performed better than expected in the 2009-10 fiscal year.

The pension fund's assets at the end of June were enough to cover 71 percent of its accrued liabilities over the next 30 years, down from 78 percent a year earlier.

The number itself isn't cause for alarm but is headed in the wrong direction, said Ed Derman, CalSTRS' deputy CEO, who discussed the latest projections from the fund's accountants in a conference call with reporters.

At this rate, he said, the system will run out of money to pay benefits in 2042 unless workers, school districts and the state work out a long-term plan to fix the funding problems. The report will be presented next week to the CalSTRS board, but any fix would require action by the state Legislature.

The funding shortfall results from numerous factors, especially from steep investment losses during the Great Recession, and hits just as a wave of baby boomers begins entering retirement. Longer life expectancies than planners projected when they set up the system also are increasing costs.

"CalSTRS needs a significant increase in revenue to make progress toward its funding target," the actuarial report said.

That could come through higher contributions from workers, school districts or the state, as well as higher returns on investments than currently projected.

"This once again shows how much pension reform is needed because the taxpayer is on the hook," said Assemblyman Allan Mansoor, R-Costa Mesa, who is vice chairman of a committee that would review any bill asking for increased contributions.

Unlike the California Public Employees' Retirement System, the teachers' fund cannot set the amounts that workers, employers and the state must pay toward retirement benefits.

Contributions for the teachers fund are set by statute, while the trigger for the increased state payment was written into law more than a decade ago. The $688 million payment from the state's general fund required under the trigger already has been factored into the governor's budget calculations for 2011-12, even as California faces a multibillion dollar deficit.

As recently as 2000, CalSTRS had more than enough assets to cover the retirement promises it had made to teachers and school administrators. The fallout from the dot-com bust that started at the end of the 1990s began eroding investment returns, which plunged during the most recent recession.

News of the shortfall comes amid a national debate over pensions for public employees and as conservatives in California seek changes to the lifetime defined benefit plans offered state workers, perhaps through a future ballot initiative.

Critics contend the plans — which guarantee certain benefits based on workers' salaries and how long they worked — provide richer benefits than those offered to private sector workers and underestimate costs, leaving taxpayers on the hook for the unfunded liabilities. Several proposals have been floated in California to reduce pension benefits for current or future workers, but they face significant legal or political hurdles.

Most of the jump in the teachers fund shortfall came because of the way the number is calculated, the fund's accountants said. The fund took an enormous hit to its stock portfolio when the market plunged during the heart of the recession, losing nearly $43 billion — roughly 25 percent of its value — from June 2008 to June 2009.

The teachers fund spreads that loss over three years when it calculates its long-term obligations. Even though the stock portfolio has been posting annual gains close to 13 percent over the past 18 months, the gains are being buried in the calculation by the much larger 2008 losses.

The teachers fund portfolio was worth $146.4 billion as of Dec. 31, 2010. CalPERS, the nation's largest public pension fund, covers 1.6 million retirees and government workers and their families, and had a portfolio worth $225.7 billion on Dec. 31.

CalSTRS members who retired during the 2009-10 fiscal year received a median individual benefit of about $49,000 a year, meaning half received less and half received more. Its members are not covered by Social Security.

About 2.2 percent of the 220,000 members receiving benefits are paid more than $100,000 a year, including spousal and survivor benefits.

The pension fund for California's teachers is facing a $56 billion shortfall, even as its investments are doing better than expected.

The drop reported Thursday is enough to trigger an automatic increase in the amount the state must pay into the nation's second largest public pension fund. Payments from California's general fund will increase by 20 percent in the coming fiscal year, to $688 million.

The shortfall grew by more than $15 billion in one year. The fund now has enough assets to cover just 71 percent of what it will owe retirees over the next 30 years.

That's mainly because it suffered huge losses during 2008 and 2009. Even though investments have been rising faster than expected for the past 18 months, it's not enough to offset the losses.

Established in 1913, TheCalifornia State Teachers' Retirement System (CalSTRS) is one of the oldest state supported pension funds. CalSTRS is the largest teachers' retirement fund portfolio in the country, and also the seventh largest public pension fund in the world. The pension fundprovides retirement, disability and survivor benefits to almost 900,000 state educators working in the state of California.

After seeing huge losses during the financial crises, CalSTRS is still trying to recover its asset base, particularly real estate investments. The pension fund's portfolio managers run several diversified investments. As of February, CalSTSR's asset allocation is as follows (click to enlarge):

Asset Allocation for the Period Ended February 28, 2011

Assets

Market Value($ million)

Actual

Target

Difference

Range

Global Equity

83,591

55.7%

54.0%

1.7%

48 - 60

Fixed Income

26,819

17.9%

21.0%

(3.1%)

18 - 24

Real Estate

16,473

11.0%

11.0%

(0.0%)

8 - 14

Private Equity

20,055

13.4%

12.0%

1.4%

9 - 15

Cash

1,255

0.8%

1.0%

(0.2%)

-2 - 4

Absolute Return + Alpha

1,895

1.3%

1.0%

0.3%

0 - 4

Total Investment Assets

150,088

100.0%

100.0%

CalSTRS' largest asset allocation is in global equities. The retirement portfolio has $83.5 billion invested in global equities. Approximately 30% of these holdings are 'actively managed' by 'professional' portfolio managers employed by CalSTRS. According to the latest filings submitted to I-Metrix Edgar-Online, CalSTRS' largest actively managed equity holdings are as follows:

CalSTRS has a unique equity portfolio where 11 out of 30 top holdings are technology stocks. The pension fund's portfolio managers favor high-tech stocks with research and development centers in Silicon Valley. The largest technology investment is Apple, followed by IBM, and Microsoft. The portfolio also has significant investments in energy equities. Exxon and Chevron are two companies favored by its portfolio managers. The sector breakdown of CalSTRS' portfolio looks like this:

The year-to-date performance of this actively managed portfolio is mediocre. The value-weighted return of top equities is 5.13%, below the S&P 500's (SPY) return of 5.58%. While the ytd performance of energy stocks was outstanding, CalSTRS' technology picks returned only 2.44%. Microsoft and Cisco were the most disappointing picks, returning -7.71%, and -141.%, respectively. The total damage to California's teachers just by those two companies was $27.84 million and $28.12 billion, respectively. The following graph offers sector-wide performance analysis:

The only conglomerate, General Electric, was a brilliant choice since the stock's ytd return is 10.74%. Exxon and Chevron provided fantastic capital gains that amounted to $101.43 million and $59.55 million, as well. Pfizer, a dividend aristocrat, gained 17.35%, boosting the actively managed portfolio by $40.65 million.Apple, and IBM were other great stock picks returning 11.92%, and 8.08%.

A quick comparison of the actively managed portfolio with the 3rd quarter of 2010 holdings shows no significant adjustments. Almost all of the holdings are slightly increased, generally by no more than by 0.5% to 1%. The only major change was increasing the Citigroup holdings by 7.34%.

However, Citi shares lost 5.92%, costing the retirement portfolio $10.59 million. The year to date performance of this actively managed portfolio is below the market benchmark.

Perhaps it is time for California's teachers to question whether active management is a good strategy, given the underperforming return of their actively managed retirement portfolio.

CalSTRS is widely regarded as one of the best large US pension plans but it took a beating in 2008 and is still trying to get out of a hole. Many other large plans are in the same situation. The analysis above focuses only on public stocks, not on private equity and real estate portfolio. The fact that CalSTRS is long technology and energy might seem like they're taking big risks, but I think it's a smart move. The same goes for their increase in Citi shares.

But bear in mind CaSTRS also has one of the largest and best performing private equity portfolios which is still performing well even though it got hit after the crisis. You can download the quarterly investment reports to get more information on CalSTRS's portfolios. You will also find a quarterly asset allocation and capital markets update by their CIO which is well worth reading.

As for the deficit, no choice but to increase contributions but they're set by statute so it will be hard to change. It is worth noting that an automatic increase in the amount the state must pay into CaSTRS kicked in. These deficits are cyclical but every large plan is going to have to figure out ways to address them and reduce them or else taxpayers will ultimately be on the hook. One thing I will bring to your attention, however, is CalSTRS's response to the Little Hoover Report:

On Wednesday, March 8, CalSTRS sent a letter to the Little Hoover Commission in response to its report on public pensions. The letter outlines why the recommendations would likely weaken rather than strengthen retirement security for California’s public educators. In some cases, the Commission’s recommendations could actually increase the total cost of providing retirement benefits.

The report includes broad assumptions and generalizations that do not account for differences between CalSTRS and other public pensions. The report also does not consider the legal ramifications of its recommendations, such as the recommendation to reduce the accrual of future benefits for current active members.

The CalSTRS benefit structure, on a comparative basis with other plans, is not, as the report says, “overly generous,” but rather provides a moderate benefit that replaces approximately 60 percent of pre-retirement income for members – who receive no Social Security benefits for their decades of service.

You can download the letter by clicking here and download the fact sheet on CalSTRS's funding needs by click here. The response letter is well written and states that CalSTRS "will work with stakeholders and legislators to address the funding situation in a manner that respects the budget situation facing the state and schools, while maintaining the financial security of educators in retirement."

A Liberal government would earmark an extra $700 million a year for low-income seniors and create a supplementary public pension plan to help Canadians save for retirement, Liberal Leader Michael Ignatieff says.

The party’s proposed expansion of the Guaranteed Income Supplement would provide the poorest of seniors with an extra $650 a year, Liberal officials said.

If elected, the Liberals would also quickly open discussions with the provinces to gradually increase premiums and benefits of the Canada Pension Plan, the party announced.

“Canadians who work their whole lives to provide for their families deserve a secure retirement,” Ignatieff commented during a campaign stop in Vancouver.

He said the situation is urgent because 75 per cent of Canadians working in the private sector do not have a registered pension plan.

Strengthening the CPP can only be done in concert with the provinces, Ignatieff noted. “This is a case where the federal government of Canada has to step up and provide leadership on pensions. We’ve had no leadership from Mr. Harper on pensions in five years.

“So what we want to do is sit down with the provinces . . . and work out with them how we get there. And it’s going to require something that Mr. Harper doesn’t seem to know how to do, which is sit down with the premiers and say, ‘We’ve got a common Canadian challenge, which is how to provide retirement security for all Canadians.’ ”

The main innovation promised by the Liberals is a Secure Retirement Option, or SRO, which would allow employees to top up their retirement savings through a supplementary plan administered by the CPP board.

It would allow employees and employers to voluntarily contribute to a tax-deductible retirement fund. An individual’s annual contribution ceiling would be determined by his or her RRSP contribution limit. Contributions to an RRSP and the SRO could not, when combined, exceed the individual’s annual RRSP contribution ceiling.

The Liberals said the plan would offer a low-cost, secure savings option. Ignatieff also proposed a Stranded Pension Agency to help manage the private pensions of employees left stranded when a company goes bankrupt.

In government, the Conservatives expressed interest last year in gradually strengthening the CPP but instead opted to begin work on a Pooled Registered Pension Plan, which would be administered by banks and insurance companies.

The Conservatives said they were offering this plan because negotiations with the provinces over enhancing the CPP were dragging on without agreement. Opposition parties and union leaders said the new private plan proposed by the Conservatives would do little to address the problem of low retirement savings for average Canadians.

In the recent federal budget, the Conservatives proposed an increase in the Guaranteed Income Supplement of $300 million annually to provide more assistance to low-income seniors. The NDP, which had asked for a $700-million increase, said the Conservatives’ measure was inadequate, citing it as one of the reasons the NDP would not support the Tory budget.

Four months after the Conservatives opted instead to beef up employer pensions, Liberal Leader Michael Ignatieff has revived the idea of an expanded “Big CPP.”

He also promises to match the NDP’s pet project of giving the country’s poorest seniors top-ups to the Guaranteed Income Supplement, a measure that was also in last week’s short lived federal budget.

As announced Wednesday in Vancouver, Ignatieff also promised a new Secure Retirement Option (SRO), billed as a voluntary and portable tax-deductible savings option backed by the publicly-run Canada Pension Plan.

Secure Retirement Option has same contribution limits as RRSPs

The so-called SRO would let workers save an extra 5 to 10% of pay, using the same contribution limits as RRSPs. And in an odd shot at higher-income earners, the Liberal press release says this will “prevent upper income earners from accessing an unfair amount of tax sheltering.”

That’s curious, given that the total amount of tax-sheltered retirement savings, whether through RRSPs or employer pensions, has long been about half of what it is in the U.S. or the U.K. Also, according to Towers Watson actuary Ian Markham, those voluntary contributions will erode individuals’ RRSP contribution room, which may mean no new net savings from the program.

The pension industry debated reform throughout 2010, with a gradually expanded Big CPP favoured by labour leaders. The CPP entails a form of payroll tax, with contributions split between employers and employees, so an expanded CPP would require higher premiums from both.

Tories, financial industry favor PRPPs

However, in December, Finance Minister Jim Flaherty instead unveiled proposals for Pooled Registered Pension Plans or PRPPs, aimed at letting small and medium size businesses share resources and cut costs through traditional employer pensions. The goal is to help out the estimated 3.5 million middle-income private sector workers who have no employer pension.

The PRPP has already had initial negotiations with the provinces, so is already moving down that path, Markham says. “The Feds did agree the provinces are free to force employers to offer a PRPP. I wonder if the Liberals would go down that path as well?”

Ignatieff acknowledges three quarters of private-sector workers are not in employer pensions (RPPs) but dismisses PRPPs as being fraught with “risk, complexity and hidden management fees.” They offer “little more than RRSPs already offer” but naturally appeal to the banks and insurance companies that will manage them, he said.

But the Liberal analysis is off base when it declares many RRSPs have annual charges of 2% or more. That may be true for those who hold mutual funds in their RRSPs, but it’s patently untrue for self-directed RRSPs holding individual stocks or exchange-traded funds.

Ignatieff also accuses Stephen Harper of “abandoning” the CPP and delivering no serious pension reform the last five years, conveniently forgetting 2009’s revolutionary Tax Free Savings Accounts, pension splitting and now the PRPPs.

Labour likes Big CPP, especially in addition to their lush pensions

One reason Labour likes an expanded CPP is it promises a guaranteed or “defined” benefit that will be there regardless how financial markets behave. Ignatieff reminded voters that (under Lester Pearson), the Liberals created the CPP in 1965. A backgrounder says any such expansion requires approval of two thirds of the provinces but most support a gradual expansion of the plan.

Quebec may be a problem since it runs its own QPP separate from the CPP. Ian Markham says in its recent budget, Quebec said contributions would have to be hiked just to maintain existing benefits. In addition, just two weeks ago, Quebec proposed its own version of a PRPP.

Gradual CPP expansion OK only if done right

A gradual expansion of the CPP is a good idea but only if it is done right, says Fred Vettese, chief actuary with Toronto-based Morneau Shepell. “That means responsible employers who already provide pension coverage should be able to pare back that coverage dollar for dollar to reflect the increase in CPP.”

But that’s not what labour groups have in mind, Vettese says. “They want to see a bigger CPP pension cheque in addition to the employer pension they already get, and in some cases the resulting pension will be excessive.”

Consultant Greg Hurst, of Vancouver-based Greg Hurst & Associates Ltd., agrees: “Higher CPP benefits would unnecessarily benefit those who already have good pensions. It will also cost taxpayers more money to support higher CPP contributions of public sector employers, that already offer very generous pension plans.”

This would be a pure defined contribution arrangement with one pool of assets and would be run by the Canada Pension Plan Investment Board. This isn’t a bad idea in most respects, and in fact it may be more workable than Pooled Registered Pension Plans (PRPPs), which the various provincial governments are currently struggling to define.

The one problem with SRO is that it concentrates even more of the nation’s retirement savings in government hands rather spreading risk by involving other sources, including the private sector. As the recent pension problems in the U.S., France or Spain (or even the Caisse de Depot) suggest, a government-led pension solution works well until it doesn’t.

Of the SRO, Hurst says the financial industry already delivers pension programs for employees of medium and larger enterprises at costs lower than current administration and investment costs of the CPP. He favours the Tories’ PRPP:

PRPPs have the prospect of making such lower cost options also available to employees of smaller businesses and the self-employed. For my money, the PRPP concepts of making it mandatory for employers to offer a pension plan or PRPP access, with automatic enrollment of employees with an opt-out option are likely to be far more effective in providing pensions to those Canadians that do not currently have them. Abandoning the progress made with the provinces on the PRPP Framework will only serve to further delay meaningful pension reforms.

Both are possible but three-way balance needed

Actuary Malcolm Hamilton, worldwide partner with Mercer’s, has said he favours a “modest” expansion of CPP but that the gradual nature of it will be of little use to those already near retirement. There’s room for both an expanded CPP and PRPPs, he told me in December.

Most financial planners believe retirement should be like a three-wheeled tricycle, with income coming from a government wheel, employers and private savings. Government already provides Old Age Security, GIS and the CPP (albeit with premiums from employers and workers), while individuals have RRSPs, TFSAs and taxable investments.

It’s the employer wheel that seems wobbly and it seems to me that by focusing on employers, the Conservatives’ PRPPs provides more balance than a Big CPP. But it’s no surprise proponents of Big Government also want a Big CPP.

Mr. Chevreau makes some good points on the success of TFSAs, introduced by the Conservatives, but his defense of PRPPs and his attack of supplementary CPP is way off base. It shows that he has no clue whatsoever about the benefits that come from having retirement money managed by the Canada Pension Plan Investment Board (CPPIB) or other large Canadian defined-benefit plans. Let me go over Mr. Chevreau's main points and highlight my concerns.

First, any article that cites actuaries and investment experts from private firms like Towers Watson, Morneau Shepell, Greg Hurst & Associates Ltd and Mercer is hardly objective. Mr. Chevreau should disclose what percentage of their business comes from private Canadian businesses as opposed to the large Canadian defined-benefit (DB) plans? I hazard to guess that almost all their business comes from the private sector as opposed to the large public DB plans which is why they're not going to publicly endorse an expanded CPP proposal full force. It's too bad the Office of the Chief Actuary of Canada can't comment on what these actuaries are stating about a supplementary CPP proposal.

Second, while it's true that an expanded CPP would require higher premiums from both employees and employers, Canadians want expanded CPP. It's not just public and private labour unions who are backing this proposal, most Canadians are worried about their retirement and rightfully so. Unlike public sector workers and politicians who enjoy the security and peace of mind that comes from their defined-benefit pension plans (which they contribute to), many Canadians in the private sector have little or no savings in the form of RRSPs.

Third, Mr. Chevreau states that the Liberal analysis is "off base when it declares many RRSPs have annual charges of 2% or more" adding "that may be true for those who hold mutual funds in their RRSPs, but it’s patently untrue for self-directed RRSPs holding individual stocks or exchange-traded funds (ETFs)." Mr. Chevreau doesn't bother researching what percentage of RRSPs are self-directed. Everyone in the financial industry knows that mutual funds are the most common investments in RRSPs, and as I stated many times before, Canadians who are able to save in their RRSPs are getting raped on fees in their mutual fund investments.

Moreover, only a tiny minority of investors with a self-directed RRSPs investing individual stocks or ETFs are outperforming any of the large Canadian defined-benefit plans over the last 10 or 15 years. And as I've stated many times before, defined-contribution plans or PRPPs can't compete with the large Canadian defined-benefit plans. Why? Because the latter are able to pool billions in assets, negotiate lower fees, manage a substantial portion of assets internally (thus lowering costs) and invest and co-invest with the best public and private fund managers across the world. For example, most Canadians are clueless about CPPIB's investment partners, but I assure you that no DC plan I know of can invest in Brevan Howard, Bridgewater, Apax, Lone Star, Texas Pacific Group or any of the other top public and private funds listed on their site. This is an important source of alpha, on top of the internally generated alpha, adding basis points on their beta (benchmark) portfolio. Over the long-term, all that alpha adds up, which is why CPPIB pays these managers big fees but they're delivering meaningful alpha.

Fifth, I take issue with Mr. Vettese's following statement:

The one problem with SRO is that it concentrates even more of the nation’s retirement savings in government hands rather spreading risk by involving other sources, including the private sector. As the recent pension problems in the U.S., France or Spain (or even the Caisse de Depot) suggest, a government-led pension solution works well until it doesn’t.

Spreading risk across the private sector? Who are we kidding here? Yes, most of the large Canadian public DB plans got clobbered in 2008, but many have bounced back nicely and have implemented serious risk management policies to manage their liquidity risk and protect their downside. When private companies with DB plans go belly-up, their pension obligations don't magically disappear. The government and taxpayers are on the hook for a portion of their pension obligations. Just look at the Nortel debacle.

That brings me to my final point. Diane Urquhart sent me the video below and an article stating that the federal government of Canada has been stonewalling Nortel's disabled by killing Bill S-216 and Bill C-624. We have serious problems in Canada which I've already alluded to in my comments on the Canada bubble and Canada's mortgage monster, but one thing we can all agree on (I hope) is that we have to defend the rights of society's most vulnerable. It's morally wrong to stonewall the demands of Nortel's disabled because the creditors don't want to be placed behind pensioners and the disabled. Pensions and the rights of the disabled must transcend politics. Let's do the right thing and give these people what they rightly deserve and introduce essential changes to the Bankruptcy and Insolvency Act to make sure this injustice never happens again. Don't worry, Big Business and Big Banks will survive.

Tuesday, March 29, 2011

Large U.S. pension plans experienced record sponsor contributions last year, consulting firm Milliman Inc. reported in a study, saying a decline in discount rates fueled record levels of pension expense and cash contributions.

In its study of the 100 largest defined-benefit pension plans, Milliman said the pensions went into the year expecting to make contributions of $30.3 billion collectively, but the final number almost doubled that estimate, rising to $59.4 billion.

Funded status for 2010 "changed only modestly," Milliman said. In August, falling interest rates drove up the projected benefit obligation and resulted in the largest deficit since the firm began the annual study 11 years ago.

The plans had asset returns of 13% last year offset by a liability increase of 7.7%, and asset allocation didn't change significantly, Milliman reported.

The funding levels of pension plans sponsored by large, publicly held U.S. employers improved slightly in 2010 due to strong investment returns and hefty contributions, according to a Milliman Inc. survey released Tuesday.

Defined benefit plans offered by 100 U.S. employers with the largest pension programs were, on average, 83.9% funded during 2010, up from 81.7% in 2009 and 79.3% in 2008, according to the survey.

On average, plans earned 12.8% on assets last year, down slightly from 14.1% in 2009 but a huge improvement over 2008 when investment losses averaged 18.9%.

In addition, employers contributed a record $59.4 billion to their plans last year, up from $54.1 billion in 2009 and $29.8 billion in 2008.

“This was a record year for pension contributions, though the number could have exceeded $60 billion if a few things had gone differently,” John Ehrhardt, co-author of the “2011 Milliman Pension Funding Study,” said in a statement.

“Pension funding relief enacted last summer helped reduce the funding burden, along with positive investment performance. If interest rates remain at current levels (or decline), contributions will be even higher in 2011,” added Mr. Ehrhardt, who is a principal and consulting actuary in Milliman’s New York office.

In all, the market value of the plans’ assets increased about $115 billion to just more than $1.2 trillion. The value of plan obligations increased nearly $103 billion to about $1.43 trillion, Milliman said.

Even with the improvement in funded status, plans’ funded ratio was the fourth-lowest since the Seattle-based actuarial consulting firm began the surveys in 1999. The lowest average funded ratio was 79.3% in 2008, when the equities markets’ slump sharply reduced the value of plan assets. The highest average funded ratio was 130% in 1999.

Milliman, Inc., a premier global consulting and actuarial firm, today released the results of its annual Pension Funding Study, which consists of 100 of the nation's largest defined benefit pension plans. In 2011, these plans experienced asset returns of 12.8% (a $115 billion improvement) that were offset by a liability increase of 7.7% (a $103 billion increase) based on a decrease in the discount rate. The decline in discount rates fueled record levels of pension expense for these plan sponsors. Collectively, these pensions went into the year expecting a $30 billion charge to earnings, with the final number almost doubling that estimate, at $59.4 billion.

"This was a record year for pension contributions, though the number could have exceeded $60 billion if a few things had gone differently," said John Ehrhardt, co-author of the Milliman Pension Funding Study. "Pension funding relief enacted last summer helped reduce the funding burden, along with positive investment performance. If interest rates remain at current levels (or decline), contributions will be even higher in 2011."

While the funded status for the year changed only modestly, the year was marked by several significant events. In August, falling interest rates drove up the projected benefit obligation and resulted in a record deficit for the 11 year history of this study. Over the course of the year, several companies adopted new accounting approaches, which involved full or substantive recognition of accumulated losses and a larger charge to 2010 balance sheets. Had similar accounting changes been instituted across all of the companies in this study, the resultant charge would have totaled $342 billion.

"For the year, the asset allocation of these 100 pension plans did not change significantly, as investment in equities only decreased from 45% to 44%," said Paul Morgan, co-author of the Milliman Pension Funding Study. "Fixed income allocations were unchanged at 36%, but allocations to other (alternative) investments increased from 19% to 20%. On average, there were not many changes, though we did see eight of the 100 companies decrease their equity allocations by more than 10%."

You can read the Milliman analysis by clicking here. It clearly shows that large US corporate defined-benefit plans are doing modestly better but are still struggling. The study ends by looking at what to expect in 2011 and beyond, noting that "even with the improvement in funded status during 2009, 2010 and thus far in 2011, most plan sponsors will still face increases in pension expense and contribution requirements. Overall, the plan sponsors in this study group have a significant asset-liability mismatch, thereby exposing their plans to relatively high funded status and future contribution volatility." Despite the low interest rate environment, the study recommends risk management practices that adopt liability-driven investing and risk budgeting (risk allocation) techniques.

Interestingly, it is also worth noting that unlike the large US public plans, corporate plans have not been as aggressive allocating to alternative investments and some companies, like GM, are looking to “de-risk” their pension portfolio by investing less in equities and real estate, and more in fixed income assets. It makes you wonder who is going to turn out to be right over the next decade.

The other thing that caught my eye was the new accounting rules that 12 companies adopted leading them to increase allocations more than 5% to other asset classes. The study states that "the allocation increase to other asset classes was partially attributed to diversification strategies and partially attributed to changes in GAAP reporting requirements under FASB ASC Subtopic 820-10 (formerly known Statements of Financial Accounting Standards Number 157), which require significantly greater detail on asset allocation." The PR Newswire article above states that if the accounting changes been instituted across all of the companies in this study, the resultant charge would have totaled $342 billion. WOW!!! It also means that as more companies adopt these new accounting rules, they will have to increase their allocations to other asset classes. Stay tuned.

Monday, March 28, 2011

The hedge fund industry's strong rebound from the credit crisis has prompted investors to ask whether some funds have grown too large and inflexible to keep delivering bumper returns for which the sector is famous.

The growth of big funds -- helped by strong returns during the credit crisis and some clients' belief that risks are lower than in start-ups -- helped push industry assets to $1.92 trillion at end-December, close to the all-time high in 2008, according to Hedge Fund Research.

However, with the growth of big funds has come the old question of whether they could be stuck if another crisis hits, whether liquidity forces them into less profitable markets and whether their prized trade ideas will be discovered by rivals.

"By definition a supertanker can't be as nimble as a speedboat," said Ken Kinsey-Quick, fund of hedge fund manager at Thames River, part of F&C, who prefers to invest in funds below $1 billion in size.

"They won't be able to respond to market conditions, especially as markets become illiquid. They can't get access to smaller opportunities, for example a new hot IPO coming out of an investment bank -- if everyone wants it then you'll only get a few million dollars (worth)."

Funds betting on bonds and currencies, and CTAS -- which play futures markets -- in particular have grown strongly.

Brevan Howard's Master fund, which is shut to new clients, has grown to $25 billion after gaining around 20 percent in 2008 and 2009, while Man Group's computer-driven AHL fund is now $23.6 billion, helped by a 33 percent return in 2008.

Meanwhile, Bluecrest's Bluetrend fund, which has temporarily shut to new investors in the past, has nearly tripled in size since the end of 2007 to $8.9 billion after a 43 percent gain in 2008. And Louis Bacon's global macro firm Moore Capital has grown to $15 billion after a good credit crisis.

LIQUIDITY

While capacity varies between strategies, some clients worry about the time it can take a big fund to sell a security in a crisis. Even in today's markets a small fund can sell a position with one phone call while it may take a big fund a morning.

"It's even more difficult than before the crisis to turn around your portfolio. Liquidity in the market is not back to where it was. A fund of $20 billion in 2007 was easier to manage than it is now," said Philippe Gougenheim, head of hedge funds at Unigestion.

"Because of poorer liquidity you're paying a higher price to get in and out of positions. Given the current political and macroeconomic environment it's important to be able to turn around your portfolio very quickly."

Big funds may find it hard to keep trades secret long enough to implement them, especially when buying or shorting stocks.

One hedge fund executive told Reuters his firm's flagship fund, once several billion dollars in size, used to break up trades between a number of brokers or initially sell a small amount of the stock -- which could give the market the impression it planned to sell more -- before buying heavily.

Meanwhile, Unigestion's Gougenheim said fixing a meeting with managers of big funds can be hard -- if a manager runs most of the money they can be hard to pin down, while if they run a small part it can be hard to find out who runs the rest.

"NOT AN ISSUE"

However, fund executives say markets are liquid enough.

"Size is not an issue whatsoever," Nagi Kawkabani, founding partner at Brevan Howard, told Reuters, adding that the fund's gross exposure -- the sum of bets on rising and falling prices -- was lower than at the start of 2008.

"Markets are much bigger and deeper than they were five or 10 years ago." Brevan would return money to clients if funds became too big, although there are no plans at present, he said.

Thames River's Kinsey-Quick said big CTAs could find it hard to trade smaller markets, although they may take small bets in these markets to show clients they can play them.

An AHL spokesman said size was "a major advantage... It gives us great purchasing power with brokers which translates into tighter spreads whilst paying pay lower commissions."

Hedge funds are one of my favorite topics. One of the best jobs I ever had in the pension industry was working with Mario Therrien's group at the Caisse de dépôt et placement du Québec, allocating to external hedge funds. I was the senior analyst responsible for analyzing and covering directional hedge funds: Long/Short equity, short sellers, global macro and commodity trading advisors (CTA) funds. It was a fun job because I got to meet a lot of managers from different backgrounds and talk markets with them. I also learned about their strategies and the differences between directional and market neutral alpha strategies.

No matter who was sitting across the table from me, I never shied away from asking tough questions on their organization, operations, investment process and risk management. Allocating money to hedge funds isn't a job for the shy and timid; you got to be able to grill them when you need to. But I also listened carefully to their responses, paying close attention to how they addressed difficult periods. The best hedge fund managers aren't uncomfortable talking about periods where they lost money and how they coped. Anyone can talk up a great game when they're making money but very few managers have the self assurance to talk about the difficult periods. For me, those discussions were crucial and told me a lot about the manager, and more importantly on the organization's culture and depth. The toughest part of that job was the constant traveling which takes its toll.

Preqin research shows that the number of public pension systems investing in hedge funds has increased significantly over the past four years. There are now 295 public pension plans worldwide known to be allocating to hedge funds, up from 196 in 2007. The mean allocation to the asset class has also grown in the same period from 3.6% to 6.6%; it is now one percentage point higher than the average private equity allocation of these investors.

They seek absolute returns of 6.1%, lower than the average expectations of other investor types which stand at 7%.

Funds of hedge funds are popular with pension funds – four-fifths of public pension systems that made their first hedge fund investments in 2010 did so through multi-manager allocations.

70% of all pension funds investing in hedge funds have funds of funds commitments in their portfolios.

The top 10 public pension system investors in hedge funds have a collective $836bn in AUM

Public pension systems’ hedge fund portfolio performance:

As of Q2 2010, hedge funds showed positive one-year returns.

Hedge funds have outperformed listed equities over a three- and five-year period.

Hedge funds have outperformed public pension funds’ average annualized return expectations of 6.15% by producing average returns of 9.8%.

Despite negative returns over a three-year timeframe, public pension system investors have increased their allocations to the asset class; this is in stark comparison to the many high-net-worth counterparts that have reduced their hedge fund commitments during the period.

You can download the full Preqin report by clicking here. I'm not shocked to see public pension plans allocate aggressively into alternatives, which include hedge funds, private equity funds, real estate funds and infrastructure funds. Why are they doing this? Many plans are underfunded so to make up for the shortfall, they're reducing their fixed income allocation and going into hedge funds and other alternatives. As the big beta boost in the stock market matures, pension funds are focusing more on alpha strategies that can deliver returns in turbulent markets. Also, many pension funds have investment policies that limits the amount of leverage they can take internally, which is why they allocate to external hedge fund and private equity managers to increase their leverage.

Not surprisingly, the bulk of the assets have been going to liquid hedge fund strategies like global macro, CTA and L/S equity. It was two years ago when I wrote a comment on the death of highly leveraged illiquid strategies. Nothing has changed; they're still dead. Post 2008, there is a premium for liquid alpha strategies and most of the smarter institutional investors are managing their liquidity risk very carefully.

Some public pension funds know what they're doing, scoring big with hedge funds. I cringe, however, when I read that Preqin finding that four-fifths of public pension systems made their first hedge fund investments in 2010 did so through multi-manager allocations and that 70% of all pension funds investing in hedge funds have funds of funds commitments in their portfolios. I'm not a big fan of fund of funds which add another layer of fees. If by "multi-managers" Preqin meant mutli-strategy hedge funds, then that's fine (standard 2 and 20 fee structure). Keep in mind, fund of hedge funds were facing extinction in December 2008. It's amazing how fast things have turned around.

Have hedge funds grown too large? Maybe, we'll see during the next crisis, but I still favor liquid over illiquid alternatives. I would however look at allocating more to market neutral funds in this environment but be careful with the leverage they're taking. Moreover, institutional investors, especially those with little or no experience with hedge funds, should strongly consider the merits of a managed account platform that allows them to control operational and liquidity risk. The last thing you need is to invest in some fake hedge fund that defrauds you.

***UPDATE***

An industry expert shared these comments with me, which I share with my readers:

I agree with you, favoring liquid strategies vs illiquid ones. The biggest problem with illiquidity is that investors were not getting paid for providing liquidity to others. At the very least, if you take the risk of doing it, get compensated for it!!!In terms of who can use managed account platforms (MAP), I believe it applies to all kinds of investors, not only to those with little or no experience. What we’re seeing this year is the very large and very experienced going to MAP in order to better control their risks. The “cash on steroids” approach.

Finally, the size debate is a hot topic, with arguments going both ways. My take is the following: returns will necessarily diminish with the size of the HF. You can have a Bridgewater one year, but that’s just one exception rather than the norm. On the other hand, I do not agree that they are getting too big for the financial system. Goldman is the largest HF, they have permanent capital (or I should say they act like if they have permanent capital…) and their size dwarfs any hedge fund. I would be much more worried about Goldman, vs the others who manage their liquidity risk much more carefully now.

I thank him for sharing his insights with me and letting me post them here. He also sent me this Infovest21 article, which discusses how large US pension funds are increasing direct allocations to hedge funds and some are using fund of funds as subadvisors to facilitate knowledge transfer so the pension may eventually take on the internal management of the hedge fund program.

Sunday, March 27, 2011

On Sunday morning, I watched an interview on CNN's State of the Union with Candy Crowley (see video below or click here to watch it). The interview was on the US economy and the guests were two two former directors of the Congressional Budget Office, Alice Rivlin who's now a Brooking's expert, and Doug Holz-Eakin, president of DHE Consulting, LLC.

Not surprisingly, both Ms. Rivlin and Mr. Holz-Eakin were talking about cutting spending, especially entitlement spending, but they also addressed the impact that the crisis in Japan and the Middle East unrest are having on the global economy. At one point, Candy Cowley asked about the recovery in the US economy. Here is part of the exchange taken from the show's transcript (added emphasis is mine):

CROWLEY: Alice Rivlin and Douglas Holtz-Eakin, thank you both so much for joining me.

You know, every time we watch the stock market, the analysts say, well you know, the oil did this and, therefore, the stock market's done that. What is the net effect of what's going on in the world -- I know the markets don't like things that aren't settled, but what about just every day living, you know, in America, looking for a recovery that is still sluggish?

Japan, has that affected the recovery at all? And how about Libya and the Middle East in general on oil?

RIVLIN: Well, nothing is going on is good -- Japan, Libya, whatever, the high price of oil and gasoline, all of these create uncertainty and to some extent a drag on the economy, especially the price of gasoline and oil.

But none of it is major yet. Your intro emphasized all the things that might be bad, but the good news is the economy is perking along, not fast enough, very weak hiring, very weak in housing, but the rest of the economy does seem to be coming back slowly but steadily.

CROWLEY: But what -- can you really have a recovery with -- in a housing market, we keep saying the housing market hit bottom. Oh, the housing market has hit bottom. So now we've gone to the lowest ever in new home sales which are the most important, because they provide jobs in building, et cetera. Can you really have a recovery without a recovery in the housing market?

HOLTZ-EAKIN: There are two pieces to the housing recovery. The first is construction of new homes. And there we've seen the housing market go from just a really drag on the economy to about neutral. It's not adding or subjecting from growth at this point. The second piece is the value of homes, which affects deeply how families feel about their futures and their ability to spend. And there I think we're about to see the worst end. But until both of those start moving north, we're not going to see a really robust recovery.

CROWLEY: Because it undermines consumer confidence, right?

HOLTZ-EAKIN: Absolutely.

CROWLEY: And what about hiring and gas prices? Isn't there some connection there? If I'm a business and suddenly my energy costs have come up whether it's a business that involves trucks or a business that involves heating or air conditioning in the summer, doesn't -- isn't that a drag on hiring people?

RIVLIN: Yes. For some businesses, it is. The main effect is that consumers who have to buy gasoline will spend less on other things. So it's a drag from that sense. And for some energy intensive businesses as well.

But we don't have as many of those as we used to. We're not as dependent as an economy on energy.

HOLTZ-EAKIN: I think there are three lessons on the oil and gas front. Lesson number one is we have oil at $140 a barrel in 2008. And it went down not because we somehow discovered a lot more oil. No, it went down because we went into a massive global recession. As economies recovered, it was inevitable that prices were going to rise. And this was utterly foreseeable.

Second piece is that Libya's not really the concern. That's not what markets are pricing. It's the broader Middle East. Libya is 2% of oil supplies. That's not our problem. It's what happens in the rest of the Middle East.

And the third is, something like this is always going to happen. There is always some piece of bad news out there. So, the key should be to build an economy that's growing more robustly, it's more resilient to bad news that inevitably will happen. And there we could do better.

We've seen calls for more pro-growth strategies this week from Eric Cantor, for example, and it really is time to get a strategy that is about having the economy grow faster.

CROWLEY: And so what I take from you is, yeah, around the margins this isn't great for the economy. However, when you look at the current state of the economy, the sluggishness of recovery, what worries you most?

RIVLIN: What worries me most, and I suspect Doug as well, is our looming debt crisis. We've got to get past this squabbling over the federal budget for this fiscal year. That's just a squabble. But what is really important is that we're moving into a period when we will have debt rising rapidly because of the retirement of the baby boom generation and high medical care costs. And we've got to do something about that. It's got to be bipartisan, and we've got to do it soon so that we reassure our world creditors that we're on the job.

CROWLEY: Doug, can you just -- I think people know intrinsically the debt is a bad idea, and when they hear trillions and trillions, it's an even worse idea. But can you connect debt to my life, to the life of the viewers?

HOLTZ-EAKIN: Sure. If we continue down the path we're going down, in the good-news scenario, what we see is interest rates start creeping up and then elevate sharply.

That means that, if you want to buy a car; if you want to buy a house; if you want to send your son or daughter to college, it's a very expensive proposition.

It also means that the place you work can't invest in the upgrades it wants to and it really can't start giving you raises because they're carrying costs of their debt. So you see an economy that starts to stagnate, where you don't increases in the standard of living, and everyone suffers from that. And it goes on for a long period of time. That's the good news scenario.

The bad-news scenario is we see 2008 all over again, where credit freezes up and we get a sharp recession. Neither is something we should mess with.

CROWLEY: I was going to ask you, I mean, can you -- if the crisis remains a crisis and Congress can't get its act together nor do something about it, which I'm assuming is for you all cutting spending, perhaps raising taxes, some -- you know, combination thereof, could we have a worse recession than we have just experienced?

RIVLIN: Yes, we could definitely have what's called a sovereign debt crisis. We used to think that only happened to small countries on other continents, but it could happen to us as well.

That means we would not be perceived as able to get our act together and pay our debts.And our creditors would lose confidence in us. And when that happens, things go south very fast. We could have a big spike in interest rates, a big fall in the dollar and be plunged into a worse recession than the one we're climbing so slowly out of right now.

Let me comment on this exchange. First, as I stated above, given their background and ideological views, it hardly surprises me that Ms. Rivlin and Mr. Holz-Eakin are sounding the alarm on US debt and entitlement spending. But to claim the US might suffer a sovereign debt crisis is simply ridiculous. The US is the largest economy in the world by far, it prints the world's reserve currency and the risk of a US sovereign debt crisis lies somewhere between zero and zero. All the doomsayers will tell you otherwise but that's a fact.

As far as entitlement spending "run amok," we need some perspective. These aren't pension liabilities of state plans where it's difficult to cut benefits, they're entitlement programs that are based on current spending and are subject to political decisions. If they need to be cut or reformed, and if there is political will to do it, US Congress will take action.

Ms. Rivlin also dismissed rising energy prices, stating that "we're not as dependent as an economy on energy." That may be true but oil prices still matter. Rising gas prices are going to hammer consumer confidence and are ultimately deflationary, not inflationary for the economy, something that analysts keep omitting.

That brings me to Mr. Holz-Eakin's comments on housing, interest rates and another sovereign debt crisis. On housing, Mr. Holz-Eakin sounds more sanguine than others, stating that new homes construction is no longer a drag on the economy and that the he sees an end to the drop in home values. But others aren't convinced that housing is stabilizing. Diana Olick of CNBC recently wrote a comment on why housing is going through a double dip, citing these reasons:

Supply supply supply. Too much. Can't overstate that.

Foreclosures. Banks are pushing properties through the foreclosure process at a really rapid pace now. I'm also hearing they may be ramping up sales ahead of any settlement with nation's attorney's general over the so-called "robo-signing" paperwork scandal. More foreclosures on the market means more supply and more price pressure.

Mortgage applications. They are way below historical norms. All cash buyers in February rose to a record 33 percent of all buyers of existing homes. Many many Americans simply can't qualify for a mortgage anymore at a reasonable rate.

FHA: Next month the cost of an FHA loan goes up yet again. FHA loan volume dropped 26 percent in February month to month.

Consumer sentiment: Awful. No confidence in this market. Only the investors are out in droves, looking for and getting bargains. We need them, but we need real buyers as well.

Mr. Holz-Eakin also noted that they see "interest rates start creeping up and then elevate sharply". If that happens, it will kill any recovery in the housing market. But I just don't see rates rising sharply for two reasons. First, the Fed's policy remains reflate and inflate at all costs to avoid a prolonged period of debt deflation. They will continue with quantitative easing (QE) which will cap long-term bond yields. Second, without a robust housing and more importantly jobs recovery, the risks of deflation remain elevated. I simply cannot understand all these doomsayers who see hyperinflation on the horizon. Why? Because oil prices are rising again? Again, if they rise too high, too fast, it's ultimately deflationary for the US and global economy.

Mr. Holz-Eakin also stated that he sees "2008 all over again, where credit freezes up and we get a sharp recession." But to see 2008 all over again, you need a catalyst, perhaps a major sovereign debt crisis. The doomsayers will tell you look no further than Greece and the Eurozone, but as I wrote in my last comment, I'm not buying the drama. There are serious structural problems in the Eurozone, but to claim that a major European default is a "done deal" is way too easy. Importantly, when everyone is on the same side of the trade, shorting the sovereign debt of European periphery economies, then I start questioning the merits of that trade.

It's also worth keeping in mind all the macro events that rocked markets over the last year or so, starting with Dubai, Greece, PIIGS, and more recently Japan. In every case, markets were able to climb the wall of worry and head higher. This doesn't mean that it will continue or that some serious sovereign default or geopolitical crisis can't rock the global financial system again, but it speaks volumes to the amount of liquidity out there ready to soak up any major macro event.

The open-source software company is surging more than 13% out of the gates following strong fourth-quarter earnings after-the-close yesterday afternoon.

Oppenheimer (Outperform rating): “While we were pleased to see the company deliver strong results across the board, we were particularly impressed with RHT’s ability to deliver over 30% billings growth and over 20% growth in cash flow from operations ($95.0 million).” Oppenheimer says, and backs an outperform rating.

Among other highfliers, JDSU and Ciena are up about 2%. Maybe it is the 1990s again.

Semis, networking stocks and materials have been on fire following the earthquake disaster in Japan. Earnings have been strong but there is a lot of hot money flowing into these sectors too, making them very volatile. It all looks and feels like the reemergence of the tech bubble, a point covered by Jameson Berkow of the Financial Post, Bootup: Experts warn of Internet bubble 2.0:

Today in technology: With a number of new web firms expected to make public stock offerings this year, observers are growing concerned the market could be headed towards another bubble; Canada’s first offshore wind farm project wins a key victory in the regulatory process; the inner workings of the computer hacker group known as Anonymous are exposed and Research in Motion Ltd. along with several other Waterloo, Ontario-based tech giants are looking to recruit more Canadian talent.

Is Silicon Valley ‘on tilt’ again?Noted financial commentator Paul Kedrosky used a poker metaphor on Friday evening to explain why the Internet industry is about to do the same thing it did back in the spring of 2000, when the first dot-com bubble burst and an estimated US$6-trillion in shareholder value vanished. He offers a Top 10 list of reasons why that could soon happen again, among them being the extreme popularity of conferences such as South by Southwest (SXSW), or the fact that private valuations are approaching public valuations (i.e. privately-held Facebook has reached valuations as high as US$65-billion).

Steve Blank, a professor at Stanford University’s engineering school and at UC Berkeley’s Haas School of Business, has gone so far as to publish New Rules for the New Bubble. Unlike the last Internet bubble, writes Mr. Blank, the next one will involve “real” companies with real revenue and masses of real customers. Facebook, LinkedIn, Skype and Groupon are all examples of firms expected to launch IPOs in the next year or two, and all have displayed an ability to earn money and maintain a strong customer base. “But like all bubbles, these initial IPOs will attract companies with less stellar financials, the quality IPO pipeline will diminish rapidly, and the bubble will pop,” Mr. Blank cautions.

I would also caution people to avoid chasing stocks that run up too high, too fast. There is a lot of liquidity spurred by hot money, hedge funds and banks engaging in high-frequency trading, mutual fund flows, pension flows, sovereign wealth fund flows, and last but not least, retail investor flows (they're always the last ones to the party and typically get slaughtered). Tread carefully, these markets may appear easy but if you become complacent and ignore risks, you'll get killed.

I will however tell you that I feel like we're heading towards another 1999 rather than another 2008. Call it a gut feeling but I look at the stock market every single day, tracking unusual volume and which stocks and sectors are making new highs. I also study the quarterly holdings of top hedge funds and mutual funds. Right now, I see the "Risk On" trade. Will it last? Will it be in tech or so will it be in some new bubble like renewable energy? Who knows? All I know is that the liquidity party will continue on Wall Street for the foreseeable future, which is why I continue to advise people to keep buying the dips.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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